What drives oil prices?

The price of oil has an important impact on economic activity and our lives. Of all the energy sources, oil and its products represent the largest energy expenditure compared to any other individual energy source or technology; therefore, it has a significant impact on the economy. Currently, oil still plays an enormous role in meeting our transportation needs. So what drives oil prices?

I explored this subject in a chapter of my master’s thesis as I was analyzing the profitability of shale plays in a low price environment. Ultimately, oil price is determined by the economic model of supply and demand balance. However, supply and demand are affected by outside forces with many interacting factors including: geopolitical events, discoveries of new oil reserves, the financial and economic status of global economies, new energy sources and technologies, weather conditions, and decisions by oil producers including OPEC (Organization of the Petroleum Exporting Countries) and oil companies among others.

Supply and demand is also applied for natural gas prices, which I just want to briefly mention because of its increased use in daily life. One important difference with natural gas is that its consumption is seasonal but its production is not. This seasonality leads to higher prices during winter and lower prices during summer because of its use in heating and cooling systems. In the U.S. this means more natural gas is used for heating northern cities during winter (the higher the demand, the higher the price) than for generating power to run air conditioning in southern cities during summer.

Coming back to oil, the demand part is largely driven by economic development around the world as development translates into an increment in energy demand, especially in developing countries as they try to improve their standard of living. Additionally, the demand is also affected by competition with new energy sources that at the same time is driven by an increasing concern for the environment.

On the other hand, the supply part of the price function is driven by new oil discoveries (reserves additions), spare capacity of oil fields, spare capacity or lack thereof in refineries (for petroleum products), OPEC and independent oil company decisions, and even some unpredictable events like natural disasters and geopolitical events including wars and political instability, especially in OPEC nations. Regarding the OPEC, usually prices go up when the production quotas are reduced.

Many different varieties and grades of crude oil exist and that is why benchmarks are used as a reference price. There are multiple benchmarks used around the world, but these are the three main ones: West Texas Intermediate (WTI), used primarily in the U.S.; Brent, is a mix of crude oil from 15 different oil fields in the North Sea; and Dubai crude, which is from oil extracted there. Another that can also be used as reference is the OPEC Reference Basket. Some disparity exists between the different benchmarks due to API gravity, sweetness/sourness (sulfur content), and transportation costs.

Lately prices have been unstable (as always); and that is because of geopolitical events happening (as always). From U.S. President Donald Trump’s imposed sanctions on Iran and Venezuela to disruptions from Nigeria to Libya, oil buyers are forced to pay more due to limited global offer. But just in December 2018, prices were at the lowest in two years, around 42.5 $/bbl WTI, due to the market being conservative ahead of the holidays and the U.S. government shutdown. That was maybe because the U.S. is the third largest oil producer in the world.

For example, today May 13^th 2019, the price went from 62.48 $/bbl WTI due to two oil tankers in Saudi Arabia being sabotaged to 61.04 $/bbl WTI because of U.S.-China trade fears. Experts are predicting that by the end of 2019 “oil production capacity could fall to under 1% of global oil demand” if OPEC compensates for falling production from Iran and Venezuela, which is hard to do as few oil producing countries hold spare capacity. This could lead to unpredictable swings in the price of oil.

There are various modeling approaches when trying to predict oil prices given different factors and their interactions. Some models include regression, time series, and artificial neural networks among others. It sound complicated, and it is. It is difficult to include all the variables in this intricate system, especially when the relationship between them is not completely understood. Even experts in the subject get it wrong often, so do not feel bad if your prediction does not become a reality. We just need to be alert of announces made mainly by producing countries, changes and plans in oil companies (mergers, buyouts, reserves additions, technology), and see how it all unfolds.

Sources:

Bloomberg, Reuters, Wall Street Journal, U.S. Energy Information Administration

Featured Image: Getty Images